Multiplier effect

Definition

The multiplier effect occurs when a small change in sales volume leads to a much larger change in operating income. This is due to the presence of fixed costs which do not vary with sales volume.

5 Must Know Facts For Your Next Test

1. The multiplier effect is closely related to operating leverage.
2. High fixed costs typically amplify the multiplier effect.
3. It can make profits highly sensitive to changes in sales volume.
4. The degree of operating leverage (DOL) quantifies the multiplier effect.
5. A higher multiplier effect indicates higher risk and potential reward.

Review Questions

• How does high fixed cost influence the multiplier effect?
• What is the relationship between operating leverage and the multiplier effect?
• Why does the multiplier effect increase risk for a company?

Related terms

Operating Leverage:

The degree to which a company uses fixed costs in its cost structure, amplifying changes in operating income relative to changes in sales.

Margin of Safety:

The difference between actual or projected sales and the breakeven point, showing how much sales can drop before the company incurs losses.

Fixed Costs:

Costs that remain constant regardless of changes in sales volume, such as rent and salaries.